If you've turned on the television or read the financial news in 2021, you've likely heard about the rise of the so-called "meme stocks." Meme stocks are companies that have seen their share prices reach stratospheric levels after being touted on online message boards like Reddit.
GameStop, for example, shot up 400% in a single week at the end of January, and it has an incredible 52-week range of $3.77 to $483. AMC Entertainment is another recent example of a meme stock, up an astonishing 2,259% year to date. But, what does the rise of meme stocks tell us about the state of today's stock market?
Last updated: July 7, 2021
$0 Commission Trading Has Changed Market Dynamics
One of the biggest restrictions to day trading in decades past has been the cost of commissions. However, those commissions began trending down in 1975 with the rise of discount brokers like Charles Schwab. Commissions reached zero per trade with pioneering app Robinhood, and now many big-name brokers, from Fidelity and TD Ameritrade to E-Trade and many others, offer $0 trades on most stocks and ETFs. As a result, day traders and speculators are free to jump in and out of positions as often as they like without incurring any costs except extremely minor SEC fees.
The availability of no-cost trading is the perfect fuel for skyrocketing meme stocks. In the course of a single day, hordes of traders can push the prices of stocks up and take profits, then jump back in again and continue the cycle. One of the reasons “meme stocks” weren’t a thing in the past is that this type of rapid trading would have been cost-prohibitive.
Social Media Has More Stock Market Influence Than Ever
No stock can become a skyrocketing meme stock without high trading volume. The best way to get high trading volume is to round up a large number of traders. Thanks to the rise of social media and message boards, it has never been easier to get a group of investors to pile into a stock at the same time. When online commentators tout a stock and get enough investors excited, the resulting buying frenzy can be enough to trigger a short squeeze. A short squeeze essentially occurs when investors who are betting against a stock by selling borrowed shares are forced to buy those shares back as a stock’s price rises. Buying those shares back results in extra upward price pressure on a stock, exacerbating the cycle.
This type of social media influence is something unique to the new millennium. Before message boards, for example, investors heard about stocks either through newspapers like The Wall Street Journal, on the financial news media or from their stockbrokers. Now, word about a hot stock can spread like wildfire via the internet, driving up stock prices faster than ever before.
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Speculation Can Be Extremely Dangerous
The primary reason meme stocks dominate the financial news headlines is that they jump dramatically in price over a short period of time. Gamestop is one of the best examples of this, as the stock rose 400% in a single week in January 2021. This pushed the stock’s one-month return to an astonishing 1,625%. And while some traders no doubt earned fantastic returns in the stock, what’s left out of the story is how dangerous stock speculation can really be. Over the past 52 weeks, Gamestop stock has traded between $3.77 and $483, with the current stock price at $202.83, as of July 2. That means those who piled into the stock near its highs are sitting on losses of more than 50%. The same could be said of most meme stocks, which post extraordinary gains until they plummet in price. Just as $0 commissions and social media posts can rapidly drive up the price of a stock, they can also tear it down.
Stock Price Movements Can Be Divorced From Reality -- At Least Temporarily
Over the long run, stock prices follow revenue and earnings growth. But in the short term, any number of factors can drive stock prices up or down. When a stock gets hyped on a message board, for example, investors can buy it blindly, with no regard for the actual stock price or valuation. As long as buyers outnumber sellers, a stock price can continue to soar, even if the underlying company has no earnings or revenue growth to sustain such a move. In a quote attributed to economist John Maynard Keynes, "The stock market can remain irrational longer than you can remain solvent.” In other words, betting against a skyrocketing meme stock can cost you your entire bankroll, even if in the end you are proven "right" and the stock eventually meets its demise.
Speculation Can Be Fun, but It’s Not a Substitute for a Long-Term Financial Plan
At the end of the day, the reason that investors own stocks is to create wealth, and there's no denying that certain meme stocks have made some investors rich. Thus, owning these types of stocks is not inherently "wrong." However, since meme stocks trade solely on speculation, hope and rumor, they shouldn't be the basis of a long-term financial plan. While some of these stocks may generate rapid profits, they can fall back to Earth just as rapidly. This type of risk-reward profile makes them appropriate for only a small, speculative portion of your portfolio. While some commentators may try to paint the stock market as a whole with the same brush, the truth is that the S&P 500 index has never lost money over any rolling 20-year period. This makes long-term investing in the stock market more of a "sure thing" compared to the boom-or-bust reality of investing in meme stocks.
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This article originally appeared on GOBankingRates.com: The Rise of Meme Stocks Highlights These 5 Things About the Stock Market